U.S. Expanding as Europe, Emerging Markets Slow
Global growth has peaked and it is no longer synchronized across regions. While the U.S. remains in an expansion, Europe and emerging markets (EMs) are slowing, creating a regime of potential policy divergence, repatriation of investment flows into the U.S., and large currency fluctuations. Market sentiment remains weak, particularly in non-U.S. markets. Over the past few months we have gradually adjusted our portfolio into a more defensive stance, with a modest underweight to global equities. In addition, we are looking for more exposure to U.S. growth rather than international, and adding to alternative assets that offer attractive valuations and uncorrelated risk/return characteristics versus core equities and fixed income.

Following are our views on major asset classes and our positioning in them.

U.S. Equities

We hold a modest underweight to U.S. equities as part of our underweight to global equities. Within U.S. equities, we are overweight small caps and mid caps, which represent about 25% of our U.S. equity exposure. In addition, we are overweight quality and underweight value.

  • The U.S. economy remains in an expansion, and it is the only region around the world experiencing accelerating growth momentum, supported by strong labor markets, corporate earnings, and tailwinds from fiscal expansion.
  • We expect small caps and mid caps to outperform large caps, being better positioned to benefit from domestic growth and tax cuts, while also being more insulated from weakening growth outside the U.S. Furthermore, these segments of the market offer more attractive valuations compared to large caps, leaving room to benefit from both earnings growth and multiples expansion.

European Equities

We hold a modest underweight to European equities as part of our underweight to global equities.

  • European growth has taken a pause, and it is now decelerating across countries and industries. This is one of the views that has disappointed us the most. Past economic strength did not translate into outperformance of European equities versus U.S. equities, and that strength is now losing momentum. We closed out of the overweight position we held since mid-2017.
  • The resurfacing of sovereign credit risk in Italian bond markets should be taken seriously. While the market reaction to political developments was somewhat excessive in our opinion, it is a reminder of a delicate equilibrium, especially considering the upcoming end to the European Central Bank’s QE. While we don’t expect the new government to push for an anti-euro agenda, the market will be closely watching the extent of expansionary fiscal policies, and their implications for debt sustainability.

EM Equities

We hold a neutral position in EM equities.

  • EMs growth is slowing across regions, driven by a combination of slower credit growth, softer global demand, and tightening financial conditions. The combination of rising U.S. interest rates and an appreciating U.S. dollar has taken some steam off the asset class, which has underperformed developed markets in the past three months, both in local currency and in unhedged terms.
  • We have held a positive view on EMs for two years, and we believe their fundamentals remain strong (except for the usual idiosyncratic cases) given low inflation and lack of external funding imbalances. However, we believe it is prudent from a tactical standpoint to wait for stabilization in U.S. interest rates and the U.S. dollar, as well as renewed signs of accelerating growth momentum, before reentering an overweight exposure.

U.S. Credit

We are underweight both securitized and corporate credit. We see limited upside this late in the cycle, resulting in an investment case limited to income generation net of potential credit losses. Instead, we prefer sourcing income via uncorrelated alternatives such as event-linked bonds, where we added exposure over the quarter.  Our outlook on EM local debt is also favorable, where we maintain a significant overweight.

  • While on a gradual tightening path, monetary conditions are still not restrictive in the U.S., as indicated by ongoing easing in lending standards. While we do not foresee an imminent end to this credit cycle, we believe there are better income opportunities in asset classes that are less correlated to global equities and rates, therefore diversifying risks in our portfolio.

EMs Fixed Income

We are overweight EMs local debt at the expense of developed markets investment grade credit, while dynamically hedging the currency exposure.

  • The EM sell-off in the second quarter certainly caught us by surprise given generally constructive fundamentals.  However, three quarters of the underperformance has come from the currency component; local rates have outperformed most credit assets, especially investment grade. Valuations are attractive. EM inflation remains low and continues to surprise to the downside. Real rates are higher than 3%, and the real rate differential to developed markets is the highest since the early 2000s.
  • Deterioration in trade policies was one of the main risks to our views, which is certainly materializing more than we expected. We have been dynamically hedging the currency exposure of EM local debt, since foreign exchange is the most vulnerable to announcement of new trade tariff and retaliation strategies between the U.S., China, and other trading partners.

Government Bonds

We are neutral developed markets duration.

  • Over the past month we have taken a more constructive view on duration exposure. While we believe the U.S. Federal Reserve (Fed) will continue to tighten once per quarter this year, yields have already backed up materially, and interest rates seem fairly priced at this stage. Furthermore, we continue to see deteriorating risk sentiment in international markets, driven by a combination of slowing growth and rising political risks in both Europe and EMs. Given extended market positioning in short interest-rate exposures, we believe risks are asymmetrically tilted toward a decline in bond yields in the second half of 2018.

Foreign Currencies and the U.S. Dollar

We continue to favor the Japanese yen, but have moved to underweight the euro and British pound, and have substantially reduced our exposure to EM FX. Overall, we are partially hedged versus our benchmark.

  • We remain of the view that currency markets are currently not driven by the Fed and interest-rate differentials. The deterioration in non-U.S. growth, namely in Europe and EMs, is the primary driver of dollar outperformance/foreign currencies underperformance. Our leading indicators suggest this is likely to continue, for now.

Alternatives

  • We have reached our $80 target on Brent oil prices and closed our overweight position in futures. Our fundamental analysis remains constructive, but we believe market positioning is currently extended.
  • We continue to hold a meaningful position in event-linked bonds at the expense of investment-grade credit, given attractive loss-adjusted yields and the potential for low correlation with other asset classes, especially as the credit and business cycles extend further.  We added to this position over the course of the quarter as prospects for traditional credit became more uncertain.

Main Risks to Our Views

  • Growth momentum is key. In our opinion, the slowdown in Europe and EMs is the underlying cause of recent market nervousness, and a far more important driver of asset prices compared to trade tariff announcements or political headlines in Italy. If growth were to reaccelerate, we would adjust our exposures accordingly.
  • Monetary conditions also matter.  Policy normalization in the form of rate hikes and central bank balance sheet runoff present additional potential headwinds to our overweight position in EMs local debt.  In our view, tighter financial conditions are an important driver of the pickup in realized volatility we have witnessed this year across multiple markets.  To the extent volatility in foreign currency markets causes EM rate hikes, we would reevaluate our positioning in this asset class.